Author Archives: MIT Sloan Finance Group

Two Nobel Prize winners look back, and forward, as they reflect on their famous model

Professor Robert Merton, in the classroom, 1980

“There are very few academic papers that you have a 40th anniversary for,” said MIT Sloan finance professor Stewart Myers. And yet, in honor of the anniversary of the Black-Scholes-Merton options pricing model, MIT Sloan did just that, with a two-day symposium celebrating the famous model and its widespread adoption and influence.

Capping off a day of talks featuring finance professors including Deborah Lucas and Stephen Ross as well as alumna Judy Lewent, SM ’72, was a fireside chat between Robert Merton and Myron Scholes, moderated by Myers. The group spoke to MIT Sloan students, alumni, and fellow faculty in a packed house that included the daughter of the late economist Fischer Black, as well as at least one former master’s student of Merton’s.

Merton and Scholes won the Nobel Memorial Prize in Economic Sciences for their work on the model, which provides a way to value options and dynamically hedge risk. The model, which can be applied to financial products ranging from interest rate swaps to mortgages as well as to a wide array of corporate investment decisions or “real options,” is notable not only for its ability to solve a challenging problem, but also for its rapid uptake by practitioners and its many uses.

“It isn’t just that they had a formula for a particular thing, it’s that the methodology can be applied so broadly. The range of things it can be applied to is amazing,” said Myers recently.

“The Black-Scholes-Merton option pricing model is probably one of the most successful theories in all of the social sciences,” said finance professor Andrew Lo in an interview before the anniversary event. “It is an idea that has come out of academic research that has been adopted in practice. The approach they created, not just the formula but the theoretical framework they created, launched a thousand additional research papers as well as a lot of industry practices that rely on that framework.”

Entire industries, including the exchange-traded options market, the over-the-counter derivatives market, and the market for credit derivatives, evolved based on Black-Scholes-Merton. “There are multiple trillions of dollars in each of those industries, and at the heart of each of them is the analysis pioneered by Black, Scholes, and Merton,” said Lo, who added that he “uses their ideas all the time” in his own work on quantitative models in financial economics.

Lessons learned

At the event, Merton and Scholes shared good-natured ribbing and humorous anecdotes about the model’s evolution, including a story Scholes told about giving an early public presentation of the work together with Black and waiting for Merton to reveal the grand finale—only to find that Merton, who did not appear, had overslept.

The pair agreed that they could not have imagined the model’s impact when they published their work in 1973. Indeed, the now famous paper was initially rejected by multiple academic journals whose editors deemed it “too arcane.” It was only when friends at the University of Chicago—Eugene Fama and Merton Miller—pressed their contacts at the Journal of Political Economy that the model finally made it into print.

When discussing the model’s use in practice and their own early trading experience applying it, Merton and Scholes advised the audience that even the most sophisticated model is no match for a trader with inside information. “The market knows things that the models don’t,” said Merton. “One ounce of non-public information is going to clean the clock of the smartest person with the model and no information. You have to ask yourself, ‘Is there somebody who knows more?’ Use the model, use history, but also use what the market is telling you.”

Looking ahead to the next 40 years, Scholes said corporate managers could use the model as they decide how to structure their companies in an increasingly technologically advanced world. The Black-Scholes-Merton approach could help determine whether or where to manufacture goods, for example, or which products to develop or innovations to pursue and which to abandon.

Merton added that the model could also be applied to risk management in emerging markets and that it could help central bankers better understand their risks as they strive to avoid another financial crisis. Developing financial markets like China’s could also rely on the model to build a stronger, safer financial system that appropriately transfers risk.

“I think it will be expanded and extended in many different ways,” said Lo. “One hundred years from now, people will still be reading about Black-Scholes-Merton.”

Videos from the events can be found at the MIT Sloan Finance TechTV site here: http://techtv.mit.edu/collections/mitsloanfinance/videos

New finance faculty member Jonathan Parker examines the effects of 2008 stimulus payments

Professor Jonathan Parker

In February 2008, Congress passed a $100 billion stimulus bill aimed at shoring up an an economy on the edge of freefall.

The stimulus awarded a tax rebate of up to $600 per person or $1,200 per couple in hopes that recipients would spend the money and prop up the sagging economy.

Jonathan Parker, one of MIT Sloan’s newest professors, said he believes the 2008 Economic Stimulus Act offers a promising opportunity to study a vexing question: Is household stimulus effective and good public policy?

“My research suggests that the stimulus payments did increase spending, and the extent to which they did informs us about the effects of similar policies on the economy.” Parker said. “We now have a reasonable idea about the spending responses to hitting the Fiscal Cliff or to a proposed tax change.”

“Whether the stimulus bill was good public policy, some will say ’yes,’ others will say ’no,’” he said. “That’s one of the things I’m studying.”

Parker joins MIT Sloan from Northwestern’s Kellogg School of Management, where he wrote several papers examining the impact of stimulus spending. He says at MIT he expects to continue to study stimulus spending versus austerity.

“My view is there is not a great case for either,” Parker said. “A convincing quantitative picture is still murky. A requisite for clarifying that picture is a better understanding of how firms and households behave. That’s what I’m continuously chasing.”

Parker’s path

This fall, Parker returns to MIT, where he received his doctorate in 1996. He joins an impressive roster of finance faculty at MIT Sloan, which is home to Nobel laureate Robert Merton and 2012 Time 100 honoree Andrew Lo.

“It’s a great institution with fantastic colleagues, from the grad students to the most senior faculty member,” Parker said. “It’s an exciting place to be.”

It is also a personal homecoming for Parker, who was born in Portland, Ore., but raised in the Boston suburb of Newton.

As a child, Parker couldn’t avoid being influenced by the academic life. Both parents worked at Boston University—his mother was an administrator, his father a professor of ancient Near Eastern languages and religion specializing in the ancient language Ugaritic.

While he didn’t choose economics until college, Parker’s studies began at the kitchen table.

“My mother was continuously coming up with mechanisms to make sure things were reasonably fairly divided between me and my brother,” he said. For instance, one brother sliced a piece of cake and the other brother got to pick which slice he got. “There’s something about that in economics, determining allocations in reasonable ways, understanding incentives, and thinking about how to make mechanisms that efficiently allocate resources,” said Parker.

His parents sent him to the rigorous Roxbury Latin School in the West Roxbury neighborhood of Boston. Parker went on to earn a bachelor’s in economics and mathematics from Yale University in 1988, and later a PhD in economics from MIT. The longtime headmaster at Roxbury Latin, F. Washington “Tony” Jarvis, an Episcopal priest who oversaw the school from 1974 to 2004, left a lasting impression.

“He was an inspirational figure for thinking about living for more than a house in the suburbs and the 2.5 kids and a minivan,” Parker said. “It was about doing something bigger, better, and beneficial to other people rather than measuring success in life by income.”

Work and public service

After posts at the University of Michigan and the University of Wisconsin, Parker taught at Princeton University.

In 2009, while at Northwestern, Parker was tapped to join a team of economists charged with devising a way to attach values to the assets in the government’s Troubled Asset Relief Program (TARP) portfolio. It was critical to find ways to help the government pin values to assets to protect taxpayers. There were many challenges, Parker said.

“How do we value claims the government holds against AIG, Citigroup, and most of the smaller banks in the U.S.?” Parker asked. “Many of the claims on these institutions held by the U.S. government—and so taxpayers—were not traded in the marketplace, so how do you figure out their worth? Given that some may not pay the government back, and the government controls policies that influence whether they will be able to, how do you price the risk in these banks?”

Parker’s work studying the efficacy of stimulus spending started at Princeton with the tax rebates of 2001, and continued at Northwestern. There he set out in several studies to measure exactly what households did with their stimulus checks, and why, with an eye toward influencing future policy.

What they learned was that after rebates arrived, households raised spending 10 percent in the first week and 4 percent in the following seven weeks, then the spending trailed away. Almost all consumer spending was by households with incomes of $35,000 or less and with two months or less of liquid assets.

Parker said it is tough to sell stimulus programs if households believe they don’t work and are costly because they add to the nation’s long-term debt.

“The $64,000 question is, ’What do we do now—with the US debt to GDP as high as it is and a perceived need to increase spending for demand?’” Parker said. “There’s a tough trade-off because household spending reflects not just cash flow, but also future concerns about who’s going to pay, and will there be a default crisis?”

His research so far doesn’t give a clear answer—stimulus or austerity. But then again, no one has the answer yet.

“Economists who get on TV and say ’I’m sure we should do more stimulus’ or claim that the only way forward is austerity, they are not getting there from the academic evidence they’ve read,” Parker said. “They’re getting there from somewhere else.”

“I’m always humbled by how little we know,” Parker said. “The world is infinitely more complex than our economic models. So we’re continuously learning. Some of the biggest questions in economics are still up for grabs.”

Third MIT Sloan finance forum examines interconnected finance systems and China’s role in the world economy

Professor Robert Merton

More than 200 finance professionals and MIT Sloan alumni gathered in Shanghai this month for a day of discussion on the future of modern finance, the third in a series of forums that bring MIT Sloan faculty around the world for frank discussions about finance and policy.

“[MIT Sloan] has the responsibility to lead and develop what the world needs for finance,” dean David Schmittlein told the audience at the July 19 event. “It’s important for us to develop the concepts and methods that will allow us to develop the complex, sophisticated financial systems that the world needs, with a resilience that the world also needs.”

“The world needs more smart people who understand complex financial systems,” he said. “Not less.” MIT Sloan this year launched the MIT Sloan Center for Finance and Policy.

Sound modern financial systems are built using expert knowledge to interpret vast amounts of data. To contribute to the discussion, MIT Sloan professors Deborah Lucas, Robert Merton, Jun Pan, and Stephen Ross shared their latest research on financial models and systems that address some of the challenges in modern finance.

And MIT Sloan alumni covered a range of topics in two panels. On one, two of China’s top financial professionals discussed the role of finance in emerging markets, while another group discussed ways to lead the financial organizations of the future.

Finance is becoming increasingly important for emerging markets

Shanghai, China’s financial capital and aspiring world financial center, was an apt location to discuss the role of finance in the growth of emerging markets. Leaders in emerging markets are seeking to better manage growth, gathering more knowledge and talent from the financial field than ever before.

“The era when very few Chinese financial professionals were up to date with the latest academic research findings is over,” said Haizhou Huang, managing director and head of the sales and trading department of China International Capital Corporation. There is an “ever-increasing number of Chinese financiers being educated at leading institutions like MIT Sloan,” he said.

Emerging markets are also challenging the post-2008 financial crisis system. Huang pointed out the benefit of China’s lack of heritage in finance, suggesting it gives China “an opportunity to create finance for the future, with a completely new financial system.”

Interconnectedness in finance can be a strength

Increased interconnectivity of global financial markets, a phenomenon of the modern financial system that was widely commented on during the crisis, was a key theme throughout the forum.

Professor Robert Merton, a Nobel laureate, introduced a new approach for analyzing and managing macro financial risks by leveraging the many connections between financial bodies that makes the world of finance so complex.

Merton’s goal is to “figure out ways to convey information with vast connections and numbers in a fashion that’s useful in trying to understand what’s going on.” He believes his approach will help guide finance professionals toward asking prescient questions when examining global markets.

Rather than view the complicated interconnectedness of financial systems as problematic, Merton was optimistic.

“The mere observation of growing connectedness is not in itself a suggestion of contagion or systemic risks. It may even be a reflection of the improvements in the global system,” he said.